Market Forecasting is Dead


The ability to forecast the markets is dead. It can also be argued that it never existed.

Regardless of that oversight, we are entertained by a constant stream of “experts” on financial media who profess to understand why the market has acted on any given day, or how it will act tomorrow. Everyone of them is trying but very few get it right. When they do get it right you can attribute it to pure chance, as their track records for being consistent are far and few between.

Many investors, individual as well as institutional, rely on market experts and forecasters when making investment decisions, regardless of the fact that they keep coming up short. For example, on 3 January 2015 Thomas Lee predicted that the S&P 500 index would be at 2325 one year from his prediction. The S&P 500 ranged between 1867 and 2122 during this period, and closed at 2012 on 4 January 2016, well short of the goal. There have been several previous analyses of forecaster accuracy, both in academic literature and also in the financial press in the past. Although many will correlate with the S&P 500 during years of stability (where you could essentially just apply a variety of statistical methods to extrapolate into the future), they have been seen to be surprisingly unreliable during major shifts in the market. For example, an analysis by Nir Kaissar found that the strategists overestimated the S&P 500’s year-end price by 26.2 percent on average during the three recession years 2000 through 2002, yet they underestimated the index’s level by 10.6 percent for the initial recovery year 2003.

There are a variety of reasons why forecasting the markets is a futile exercise. As Nassim Taleb puts it - “The tragedy is that much of what you think is random is in your control and, what’s worse, the opposite.” Regular savings are in your control, your expectations and behaviour is also in your control, however, stock market moves in an uncertain world are not.

 

GAAP

Fundamentally, businesses usually go public to raise capital in hopes of expanding. The ownership of the business is then spread among a large group of shareholders. If the company’s earnings are solid and consistent, the share price is valued higher and the shareholders get rewarded for putting their money at risk. These companies issue quarterly and yearly earnings reports in order to provide current and any potential future shareholders a snapshot of the health of the company at that moment. To do so they usually apply what we call, “Generally Accepted Accounting Principles.”

But as the MIT Sloan Management Review recently pointed out,

“Lurking within the financial statements and communications of public companies is a troubling trend. Alternative metrics, once used sparingly, have become increasingly ubiquitous and more detached from reality.”

They went on to provide the following example:

“In 2011, Groupon Inc. announced plans for a highly anticipated initial public offering. But enthusiasm for the offering waned when the U.S. Securities and Exchange Commission (SEC) issued a comment letter questioning Groupon’s use of a profit metric it called “adjusted consolidated segment operating income.” To our knowledge, no company had ever used that metric before; it was intended to measure operating profit without including marketing expenses, stock-based compensation, and acquisition-related costs. Management argued that a $420 million loss from operations reported on its 2010 income statement should really be considered a $60 million gain.”

This is not an isolated example, and the use of these so called, “accounting tricks” have only become more sophisticated. What was once analysis of a businesses operations and their ability to satisfy customers and grow has become an exercise of forensic accounting analysis in order to spot the manipulators! Try forecasting the next clever income statement adjustment!


The Federal Reserve

What were once pretty much free markets have become markets that have become pretty much dependent on the next Central Bank intervention. QE1 took place in November 2008 when the Fed spent $600 billion on purchase of Mortgage-backed Securities (MBS) in order to “save” the financial system from ruin (which could be argued that they facilitated in the first place). But they didn’t stop there. They continued with QE2, Operation Twist, Operation Twist Extended and QE3. It didn’t stop with the Fed, as they do work closely with their central bank colleagues, such as the ECB and BOJ.

Total Assets of Major Central Banks

Was there an impact on the financial markets? Of course there was. They drove interest rates pretty much to zero for an extended period. As Quicken Loans pointed out, there will be a time when the Fed has to get out of their positions and when that happens:

“A new buyer, or more likely several of them, would have to pick up the slack and buy lots of MBS in order to keep mortgage rates where they are right now. No one has a crystal ball as to when the Fed will start to get out of the MBS market, either.”

So without a crystal ball or being privy to what the Federal Reserve has planned regarding future manipulations of the market, trying to forecast them is a futile exercise that serves no purpose.

 

High-Frequency Trading, Spoofing, and other Shenanigans

In addition to accounting trickery and central bank intervention, here are a few more choice headlines and examples as to why forecasting the markets is dead.

“Six banks fined $5.6bn over rigging of foreign exchange markets”

“HSBC faces fresh suit alleging forex manipulation”

“BNP Paribas pleads guilty to forex manipulation”

“Wells Fargo Accused Of Manipulating Business Banking Data”

Since 2007 we have seen a new player in town, high frequency traders. High-frequency trading is an automated trading platform used by large investment banks, hedge funds and institutional investors that utilizes powerful computers to transact a large number of orders at extremely high speeds. This has completely changed the dynamics of the markets. As JP Morgan pointed out in their own report of June 13, 2017:

"While fundamental narratives explaining the price action abound, the majority of equity investors today don't buy or sell stocks based on stock specific fundamentals," Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates "fundamental discretionary traders" account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.

Which introduced another brilliant market manipulation called “spoofing,” and another choice headline to present:

“Gold, Silver Manipulation: CFTC Fines Deutsche, USB, HSBC For Spoofing Markets”

The CFTC announced earlier this year that Deutsche Bank, UBS and HSBC faced fines totaling $46.6 million. Deutsche Bank was the hardest hit as it was fined $30 million. UBS was ordered to pay $15 million and HSBC was fined $1.6 million.

How about naked short selling? Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.
 
Paul Craig Roberts described this process as it is used in the gold markets:

“This manipulation by the Fed involves the short-selling of uncovered Comex gold futures. “Uncovered” means that these are contracts that are sold without any underlying physical gold to deliver if the buyer on the other side decides to ask for delivery. This is also known as “naked short selling.” The execution of the manipulative trading is conducted through one of the major gold futures trading banks, such as JPMorgan Chase, HSBC, and Bank of Nova Scotia. These banks do the actual selling on behalf of the Fed.”

To see proof of this, one just has to check the latest Comex Reports to see that the current ratio of paper gold to physical gold is 176:1.

 

Conclusion

The next time you are watching your favorite financial media program providing explanations as to what the market is doing now and what the market will do,  remember the previous points. Remember to ask yourself two questions, “Does this person really have the ability to forecast the markets,” and “should I have confidence in any of their conclusions?” Because, in reality, market forecasting is dead!